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Bear Bet: An ETF That Loves Down Markets

A closer look at the UltraShort QQQ.

The UltraShort QQQ (AMEX:QID), from ProShares is different from most ETFs. This fund has the objective of achieving returns twice the opposite of the daily performance of the Nasdaq 100. If the Cubes, Nasdaq 100 Trust Shares (NASDAQ:QQQQ), lose 10 points, QID seeks to gain twice that or 20 points. It's easy to see that QID could be very useful in a bear or declining market. Investors have flocked to this fund like a bear to a honey pot, putting more than $1.5 billion into the fund since its launch in mid-2006. Of course, there are many negatives to this fund, such as high expenses and taxable gains, so QID is not for everyone.

Bear market honeyIf you want to take advantage of declines in the market, two options are to short a stock or buy an ETF. The fund can be the cheaper option, and it's easy to buy or sell.

Short sales of stock can leave you exposed to unlimited losses -- for instance, when the stock keeps rising in value after you have sold it. Just imagine if you had sold Google (NASDAQ:GOOG) short after its IPO and had to cover the position later. With a fund, your losses are limited to your initial investment. ETFs don't have maturity dates, like many derivatives, so you don't need to periodically roll over your position, and you can hold the fund as long as you want.

Clearly, QID can be useful when the market experiences peaks and valleys. Another use for this fund might be to hedge declines in your other portfolio holdings. Most investors are long the market, and since the market has a generally upward trend, that is the correct position to be in. However, when the market faces its inevitable declines, these long positions usually slide right along with most securities. A holding in QID, on the other hand, will let you benefit from the market decline and can make money while most other assets lose value.

Tax biteIn 2006, investors in the Ultra ETFs experienced something unusual for ETFs: short-term capital gains. The reason taxes bare their ugly head with QID is that it uses futures and swaps to leverage. Like a bear awakened too early from hibernation, the IRS treats these derivative instruments differently from stocks. The futures the fund holds are marked to market at the end of each year, so capital gains cannot be deferred. In addition, swaps face a 100% short-term gains tax situation. A peek at the fund's portfolio shows that it relies almost exclusively on swaps to achieve its leverage.

Clawed by negativesAs a double bear fund, QID has more variability than a typical ETF. Furthermore, since the fund tracks the tech-heavy Nasdaq 100, there's also a lack of sector diversification to consider. In addition, QID has a high 0.95% expense ratio and has a negative 26% return since inception. These factors, along with tax issues, contribute to making this fund inappropriate for many investors. At the same time, QID is different from most ETFs, and that makes it an interesting option to diversify your portfolio. QID offers a way for investors to benefit during those times when the market goes down, and for that reason this fund can be attractive.

Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She does not own any of the funds or securities mentioned in this article. The Motley Fool has a disclosure policy.